September 18th 2025.
Real estate investors are well aware of the benefits of bonus depreciation and 1031 like-kind exchanges. However, what many people don't realize is that these two rules can actually work together in a surprisingly effective way. Let's take a closer look at how this works and the potential tax savings it can bring.
The concept is fairly straightforward. Bonus depreciation allows you to immediately deduct the cost of certain property with a recovery period of 20 years or less. This includes personal property, land improvements, and some interior improvements that are identified in a cost segregation study. On the other hand, a 1031 exchange allows you to defer the gain when exchanging one property for another of similar kind.
Here's where it gets interesting: according to Treasury regulations, when you exchange into a new property, the basis from the old property and any additional investment funds can be eligible for bonus depreciation. This can be found in Reg. §1.168-1. The key point to remember is that by combining these two laws, you have the potential to significantly reduce your tax burden.
To better understand this, let's look at a simple example. Say you purchase a rental property for $1,000,000 and a cost segregation study reveals $300,000 of 15-year improvements. By claiming 100% bonus depreciation, you can deduct $300,000 in the first year. In the second year, you exchange this property for a replacement worth $1,000,000 and the basis carries over at $700,000. According to the regulations, this $700,000 can be treated as newly placed in service for bonus depreciation purposes. A new cost segregation study reveals an additional $210,000 of short-life property, resulting in another significant deduction. This same process can be repeated in the third year.
As you can see, this creates a sort of "geometric series" of deductions that can greatly benefit high-income real estate investors. However, there are a few things to keep in mind. First, transaction costs and timing are important factors to consider. Also, a cost segregation study must be performed on each property and you must have enough participation in the rental activity to avoid being classified as a passive activity.
But for active real estate investors, particularly those who are moving up in property size, this can be a powerful strategy to defer gain through a §1031 exchange while also accelerating deductions with bonus depreciation. It's important to note that this strategy may not be suitable for everyone and consulting with a tax advisor is crucial before attempting to apply it in your specific situation.
In conclusion, many investors believe they have to choose between a 1031 exchange or a large depreciation deduction. However, with the right circumstances and proper planning, it is possible to have both. As always, the details and individual circumstances matter, so be sure to consult with a tax advisor before making any decisions.
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